Experimental Finance and Paving Wall Street

I (Ross Miller) thought it best to lapse into the
first person to discuss the application of experimental economics
to financial markets, a field known as experimental finance.

I first became interested in the stock market at the
age of eleven and the first stock to catch my fancy was IBM--probably
because it traded at a much higher price than other stocks. When I was fifteen, I used a primitive
computer, the Olivetti-Underwood
Programma 101, to help me select stocks for Value Line's contest.

I was more interested in math and computers
than I was in the stock market until I was a junior at Caltech. There, I
had the incredible good fortune to take a course called "Laboratory
Experiments in the Social Sciences" the first time it was offered.
Then, in 1974, it was more like a research seminar than a
typical college course. It was run by Charles Plott and Vernon Smith, who had
been fishing buddies when they both taught at Purdue, and most of the attendees were
the rising superstars on Caltech's faculty in economics and political
science. I was one of three "paying customers" as Vernon
Smith liked to call the students in the class. At the time, I was living
across a large parking lot from the largest brokerage office in
Pasadena, which had theatre-style seating to watch the electronic ticker
tape, and I spent many mornings there trying to make sense of the
markets.

I
quickly read the few papers published about experimental markets and
found them to be
overly simplistic with little bearing on real financial markets. (Experimental economics, the testing of economic theories in a
controlled laboratory setting using human subjects paid real money, was
considered "disreputable" by the leading lights of the
economics profession until the end of the twentieth century.) I
found that these markets did not allow for what I considered the
most important aspect of market--the speculative element. My course
project involved the creation of the first true experimental asset
market and provided a crude test of Milton Friedman's assertion that
speculation exerted a stabilizing influence on markets. After the
course, which is still offered at Caltech as Ec/PS
160, was completed, Charlie, Vernon, and I conducted further
experiments and wrote them up in a Quarterly Journal of Economics
article, Intertemporal Competitive Equilibrium: An Empirical Study of
Speculation. Paving Wall Street gives my account of
that time at Caltech and Charles
Plott and Vernon
Smith have their own accounts.

I returned to Caltech as a visiting faculty member in 1981 where I
wondered if an experiment could be devised to test the signaling theory
of my main thesis advisor, Michael Spence. Any such experiments would be
a
radical departure from earlier experiments because the subjects were not
merely be led "as if by an invisible hand" to an equilibrium,
but would have to "learn" something collectively to get there. In the
signaling experiments that Charles Plott and I devised and ran, buyers
could signal that they had produced high-quality goods by adding
"stripes" to their products. Buyers had to figure out on their
own that they could do this and sellers had to learn to associates more
stripes with higher quality

It was more difficult to get signaling to work in the laboratory than
was indicated by Spence's theory. Indeed, we learned that how data was
presented to subjects influenced how quickly they figured out how to
signal. Also, we found that when subjects failed to find a signaling
equilibrium, they behaved as if one did not exist, a theoretical
possibility discovered by Michael Rothschild and Joseph Stiglitz. We
published our results in Econometrica in an article entitled Product Quality Signaling in Experimental
Markets. In several follow-up studies, Charles Plott and I
worked with Michael Lynch and Russell Porter of the U.S. Federal Trade
Commission to examine how price could be used as a signal of
quality--the key element of George Akerlof's "lemons" theory.

Finding myself at Boston University's finance department, I stopped
running experiments and starting looking into how computers could be
used in the financial markets. My research took two tracks. The
conventional track was how to use computers to determine the value of
the increasingly complex derivative securities that were beginning to
appear on Wall Street. The more radical track, inspired by my
experimental work with Charles Plott and Vernon Smith, was how to treat
the market itself as a computational device and to explore what that
meant for the design of financial markets.

My conventional work on the construction and valuation of derivative
securities took the form of a book, Computer-Aided
Financial Analysis, and a companion
article that converted a substantial amount of the book's LISP code
into Mathematica. I departed academia to try things out in real
world at General Electric. My adventures there and how they led to Miller
Risk Advisors are recounted in the Risk
Management section.

My next book had to wait until work in experimental economics became
respectable enough that a nontechnical book on the topic would interest
a publisher. (The rumor that the Swedish Academy was planning to award a
prize to one or more experimental economists was enough to do the
trick.) We managed to get Paving Wall Street: Experimental Economics
and the Quest for the Perfect Market into the stores nine months before the prize was
awarded to Vernon Smith, who wrote the book's foreword.

Paving Wall Street is my take on the world of finance from the
viewpoint of someone coming at the subject from an experimental and
computational point of view. David Warsh, the former economics columnist for
the Boston Globe, has a nice piece on the book and its
significance on his Economic
Principals website.

Paving Wall Street is available on Amazon.com.
There, one can either browse the sample pages or use the Search
Inside This Book feature to look for something specific. (I
apologize in advance to all authors of other works whom I unjustly
failed to cite.)